The credit bubble, the recession and what the Federal Reserve should have done

By Roger Lowenstein
Sunday, May 2, 2010;
B04

No, Goldman Sachs did not single-handedly launch the financial crisis, no matter what many lawmakers are saying. The turmoil that struck the markets in 2008 also had very deep roots in another powerful institution: the Federal Reserve. One of the most troubling questions in the aftermath of the crisis is why the Fed didn't intervene to deflate -- or "prick" -- the credit bubble, especially in home mortgages, before it got so big that its burst would threaten to take down the economy.

William Dudley, president of the Federal Reserve Bank of New York, recently suggested that the Fed was mistaken on that score. "The costs of waiting to respond to an asset bubble until after it has burst can be very high," he told the Economic Club of New York. ". . . A proactive approach is appropriate."

While that might seem obvious, it is not the position of either former Fed chairman Alan Greenspan or current central bank chief Ben Bernanke. Both continue to defend the Fed's monetary policy in the years prior to the crash -- and both have insisted that pricking asset bubbles is not part of the Fed's job.

Critics of the Fed have long urged it to intervene in bubbles -- an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can't know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.

What could the Fed have done about it? By law, the central bank is responsible for promoting maximum economic growth while maintaining stable prices. When bubbles burst, they wreak havoc on the economy, so reining them in should be considered part and parcel of keeping the economy growing.

In 1996, Greenspan briefly tried to talk down the stock market by wondering aloud whether stocks were infected by "irrational exuberance." But he gave up the effort, and tech stocks continued to soar. One of Greenspan's most influential supporters was Bernanke, then an economist at Princeton. In 1999 -- near the height of the dot-com mania -- Bernanke wrote that it is virtually impossible to know (until after the fact) whether a rising market reflects a speculative bubble or whether the rise is justified.

Of course, many people warned that dot-coms were fostering a dangerous bubble. But, as it still does today, the Fed continued to concentrate on inflation in consumer goods such as cars and computers while all but ignoring speculation in investment assets.

By focusing so zealously on inflation, the Federal Reserve is essentially fighting the last war. The United States' most recent bout of serious inflation occurred in the 1970s and early '80s; in response, then-Fed Chairman Paul Volcker moved aggressively to raise rates in order to curb prices. Since then, asset bubbles have been inflating and popping ever more often.

Excesses that in the past would have produced inflation now cycle back into the economy through the financial markets. The real estate bubble of the past decade was a textbook case. Instead of buying domestic goods and spurring inflation, Americans spent their dollars on cheap imports. Trade partners such as China recycled their dollars into Treasury bills. That, in turn, lowered interest rates and spurred investment in stocks and homes.

This dynamic was apparent to Bernanke, who in 2005 observed that high savings overseas had translated into low mortgage rates, which "have supported record levels of home construction and strong gains in housing prices." However, Bernanke saw the cycle as benign. Indeed, he emphasized that he was not "making a value judgment" about the behavior of the United States or other governments.

Bernanke has been reluctant to intervene in bubbles because of his philosophical belief that the markets generally get it right. In his writing, he often encased the word "bubble" in disputative quotation marks -- as if to challenge the notion that any market rise could be excessive. Greenspan's faith in markets, meanwhile, appeared to border on the theological.

We know from bitter experience that markets do err and that the errors are often detectable in real time. There was no shortage of critics who warned of a housing collapse. Moreover, the Fed does not require perfect knowledge when it raises rates to ward off inflation; it relies on a best-effort prediction that the risk of inflation is serious. It can and should act in the same way -- adjusting interest rates upward -- when it fears unwarranted inflation in investment assets.

Robert Barbera, chief economist at research and trading firm ITG, suggests a handy tool for detecting a credit bubble. Normally, risky borrowers have to pay higher interest rates than non-risky borrowers. This is only common sense: Lenders need to be compensated for increased risk. But during the credit bubble, the premium charged to risky borrowers all but disappeared. Even junk-bond issuers (the riskiest corporations) paid less than two percentage points more than the U.S. Treasury, compared with eight or nine points more when lenders were more cautious.

When risk premiums narrow so drastically, it is a sign that lenders are being silly, not smart -- and it is time for the Fed to act.

Given the severity of the recession, Barbera is betting that the Fed will intervene next time. "We are more likely to be invaded by Martians than that the Fed will ignore a simmering asset bubble in the next 10 years," he says.

This year, in a speech in Atlanta, Bernanke reiterated his view that there are "practical problems with using monetary policy to pop asset price bubbles." But he did leave room for doubt. Having experienced the pain that bubbles can cause, he promised to keep an open mind.

Bernanke should complete the conversion that he has hinted at and that Dudley has plainly endorsed. The Fed must not let America's workaday economy be jeopardized by a financial bubble again.

Roger Lowenstein is the author of five books on financial markets, including "The End of Wall Street," published last month.

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